A Cautious and Careful Approach to Private Equity

Why would you consider putting your clients in a private-equity fund of funds? Neither Morningstar nor Lipper covers them. If you’ve even heard of them, you know that fees are high — 20% of gross profit in addition to management fees. They’re also illiquid, with a life span of at least six years, according to Jerry Jacobs, chief investment officer at Waltham, Mass.-based Argent Wealth Management, which manages about $1.7 billion.

Yet, like other funds of funds, private-equity funds of funds offer “the broadest diversification you can achieve” — because of their investments across all sectors and a vast number of companies, Jacobs says. In addition to diversification, they outperform most equity index funds generally — making them a good investment, he says. So for individuals with at least $2.5 million to invest and a suitable timeline, a PE fund of funds might be the right way for a high-net-worth client to enter the private-equity asset class, says Jacobs.

Clients who fall into this category can safely devote from 5% to 10% of their portfolio into the class, Jacobs points out.

According to Jacobs, advisors should always examine the client’s capacity for illiquid investments before they move ahead with a private-equity fund-of-funds investment. He then uses laddering, which he says is “the same technique that the best endowment funds use,” to build a range of investments over a three- to five-year period. “I don’t want a huge inflow or outflow, because you might be left with cash and no good investment.”

However, there are red flags to watch for when investing in a private-equity fund of funds. These include poor historical performance, too much churn, turnaround or lack of transparency, says Robert Mason, private-equity consultant at London-based Sandaire Investment Office, a private-client firm that manages about $5 billion.

Sandaire has participated in the private-equity fund-of-funds market. Mason says, “there is definitely a place” for them for clients who can accept “moderate risk.” In his opinion, managers currently looking for private-equity fund-of-funds investments should concentrate on a segment with good opportunities going forward, like the mid market, rather than overcrowded large markets.

Sandaire sees PE fund-of-funds vehicles as being the right move “for clients seeking a relatively low risk a few percentage points higher than the quoted market, in return for the attendant illiquidity,” says Mason.

Juin Chin

Juin Chin, an investment analyst at Modera Wealth, a Westwood, N.J., advice firm with $1.6 billion in assets under management, believes a private-equity fund of funds worth investing in has a strong management team with a background in PE funds of funds.

Some private equity funds of funds can be too complicated because there are varying strategies and managers to keep track of. Chin says that Modera stays away from such funds and prefers managers who focus on a particular strategy, like a middle-market buyout.

To make good choices, always know how the overlay manager decides which funds to select, says Chin. That’s both to ensure a consistent and logical focus and to avoid managers in sweetheart arrangements with the underlying funds. “Be mindful of how people incentivize,” he warns.